Examining the last few years based on market returns, it would be easy to say that every year except for 2022 was great. It is natural human behavior to think about up markets as good and down markets as bad. In the reality of financial planning, things are not so simple. What really matters is how much spending your portfolio can support in the future — your spending ability.
There are three factors that impact potential spending ability from a portfolio:
The portfolio value and your contributions to the portfolio are straightforward data points. We know today’s value of the portfolio. With a little bit of budgeting, we can estimate your future income and expenses, so we should be able to estimate future contributions or withdrawals from the portfolio.
When it comes to the third factor — expected returns —higher long-term government bond yields are a rising tide that lifts all boats. Let’s break down what that means.
There is a strong, positive historical relationship between the long-term government bond yield and expected stock returns. That is, stocks tend to return more when interest rates are higher. Boiling down the academic research on this topic, investors require a higher expected return to invest in riskier stocks rather than safer bonds — known as the equity risk premium — and academics’ best guess of that risk premium is about 5% more per year in return. In addition, rising long-term government bond yields increase the expected return of bonds as well as stocks!
If we go through the past few years, we can use this lens to examine what happened to a typical investor’s spending ability, especially during the two big downturns in 2020 and 2022.
(When referencing stock returns and bond interest rates, we will be referring to the MSCI World Index for stocks and the US 10-YearTreasury, respectively. Any reference to a 60% stock and 40% bond investment is60% MSCI World Index and 40% Bloomberg US Treasury Bellwether 10-Year Bond Index. For illustrative and educational purposes only. Not intended to represent any strategy.)
Future Spending Ability Was Basically Flat in 2020
Even though the stock market dropped 32% from peak to trough in March 2020, the market fully rebounded and then some by the end of the year.1 From a portfolio perspective, 2020 was a good year. However, bond yields dropped from 1.92% at the beginning of 2020 to 0.93% at the end, forecasting lower forecasting lower bond and stock returns going forward.
In other words, stock markets did well, but bond yields went down (i.e., expected returns of both stocks and bonds went down), so the net effect was a slightly positive year for most investors from a future cash flow standpoint.
Future Spending Ability Was Up in 2022, Really!
It is not easy to forget the panic that gripped investors in2022. Many investors were fearful of the market.
A portfolio of 60% stocks and 40% bonds was down about –17%in 2022 with both stocks and bonds dropping similarly in value. However, the silver lining was that bond yields increased from 1.52% at the beginning of2022 to 3.88% at the end ... meaning that expected returns for stocks and bonds went up … by a lot.
Even though portfolio values were down in 2022, this jump in expected returns meant that spending ability surprisingly went up in2022 for most investors. Yes, this is a very counterintuitive result. Even with portfolios down in value, expected returns jumped by enough to more than offset the decline, creating more secure outlooks and retirements for investors in the long run.
Future Spending Ability Increased Quite a Bit These Past Five Years
Below is a visual look at the last five years in terms of portfolio return and change in bond yields. What is really striking is that all of the last five years were neutral or positive in terms of increasing future spending ability — especially the last four. We have to go back to 2018 to find a year when expectations of future wealth and spending ability declined.
This chart uses the return of a portfolio of 60% stocks and40% bonds to show a hypothetical investor’s portfolio return and the yield of10-year U.S. Treasury Bonds for interest rates. Anything up and right of the neutral line represents a straight-line increase in spending for an investor who plans to invest at least another 10 years. Notice that all five blue dots, which represent years 2020–2024, are up and to the right of the neutral line — representing higher spending ability each year.
Looking at 2024 Through a Financial Planning Lens
The 10-year U.S. Treasury bond yield ended 2023 at 3.88% and rose to 4.58% by the end of 2024, thus increasing bond and stock expected returns going forward as mentioned earlier (remember that rising long-term government bond yields increase the expected returns of stocks and bonds). The combination of higher portfolio values and higher future expected returns means that long-term wealth and spending ability look stronger than ever.
2024 ended up being a strong continuation of the last five years, providing investors with the best outlook for retirement spending and long-term portfolio values yet.
Conclusion
Viewing the world through portfolio values alone, the last few years could have felt uneasy with the drop in the market in early 2020 and the drop across stocks and bonds in 2022.
However, when we view the world in terms of long-term spending and wealth, the last five years have added a significant amount of long-term security and financial flexibility for disciplined investors.